MAY 2005
- In October 2002, the Financial Accounting Standards Board
(FASB) issued a proposal to adopt a principles-based approach
to setting accounting standards. FASB’s proposal is
a reaction to the complexity of the “rules-based”
or “cookbook” approach to setting accounting standards.
For example, Harvey Pitt, then SEC chairman, testified before
the U.S. Senate Committee on Banking, Housing and Urban Affairs
about the need for principles-based accounting standards:

Much
of FASB’s recent guidance has become rule-driven
and complex. The areas of derivatives and securitizations
are examples. This emphasis on detailed rules instead
of broad principles has contributed to delays in issuing
timely guidance. Additionally, because the standards are
developed based on rules, and not broad principles, they
are insufficiently flexible to accommodate future developments
in the marketplace. This has resulted in accounting for
unanticipated transactions that is less transparent and
less consistent with the basic underlying principles that
should apply [March 21, 2002].

FASB’s
proposal indicates that it accepts this criticism as at
least partially valid. Indeed, FASB explains that the level
of detail in recent standards is partly attributable to
political compromises made in order to gain acceptance of
a standard. The compromises include providing for scope
exceptions (exempting from the standard some otherwise covered
transactions), exceptions that limit volatility of reported
earnings, and exceptions to mitigate transition effects
to a new standard. Katherine
Schipper (“Principles-Based Accounting Standards,”
Accounting Horizons, March 2003) argues that FASB
generally follows a principles-based approach, but the exceptions
and interpretive and implementation guidance provided by
FASB may make recent standards appear to be rules-based.

In
2003, the SEC published a staff report in which the concept
of principles-based standards was clarified. According to
the report, principles-based standards “should have
the following characteristics:

“Be
based on an improved and consistently applied conceptual
framework;

“Clearly
state the accounting objective of the standard;

“Provide
sufficient detail and structure so that the standard can
be operationalized and applied on a consistent basis;

“Minimize
exceptions from the standard;

“Avoid
use of percentage tests (‘bright-lines’) that
allow financial engineers to achieve technical compliance
with the standard while evading the intent of the standard.”

Even
if FASB’s approach is generally principles-based,
as defined by the SEC, a large portion of current GAAP is
based on standards adopted before the completion of the
conceptual framework project or promulgated by FASB’s
predecessors, the Committee on Accounting Procedure (CAP)
and the Accounting Principles Board (APB). Both the CAP
and the APB were heavily criticized for their “piecemeal”
approach to setting standards, which resulted in standards
that were not consistent with each other or with an underlying
set of accounting principles (Stephen A. Zeff, “Some
Junctures in the Evolution of the Process of Establishing
Accounting Principles in the U.S.A.: 1917–1972,”
Accounting Review, July 1994). Some inconsistencies
in GAAP are related to basic recognition criteria for assets
and liabilities (e.g., noncancelable purchase agreements
versus capital leases). Other inconsistencies exist because
of differences in measurement criteria (e.g., discounted
cash flows in the case of non-interest-bearing notes versus
undiscounted cash flows in the case of deferred taxes).

Some
areas of existing GAAP seem inconsistent with the first
characteristic of principles-based standards, that they
be based on an “improved and consistently applied
conceptual framework.”

Specifically,
these inconsistencies are apparent in three areas: 1) executory
contracts, 2) valuation of future cash flows, and 3) stock
dividends and stock splits. These accounting issues represent
transactions in which a large number of companies engage,
and are relatively easy to understand. They do not represent
an exhaustive list of accounting rules where inconsistencies
exist. A discussion of these inconsistencies hopefully will
motivate FASB to resolve them in due course and to strengthen
the Conceptual Framework as a theoretical basis for future
GAAP.

Purchase
Commitments Versus Supply Commitments

Companies
enter into purchase commitments to ensure a long-term supply
of raw materials and protect themselves from future price
increases. Companies enter into supply commitments to ensure
future sales of their products and protect themselves from
future price decreases. The purchaser is trying to protect
itself against rising prices. The supplier, on the other
hand, is trying to protect itself against falling prices.

The
two primary reporting requirements for parties that enter
into purchase commitments are as follows:

Companies that enter into firm purchase agreements are
required under SFAS 47 to disclose in the notes to the
financial statements the nature of such agreements and
the timing and amount of cash payments to be made, if
the purchase commitment (a) is noncancelable; (b) was
negotiated as part of arranging financing for the facilities
that will provide the contracted goods or services or
for costs related to those goods or services; and (c)
has a remaining term in excess of one year.

Companies that have firm purchase commitments have long
been required under ARB 43 to recognize a loss in the
period in which the market price of goods to be purchased
under the agreement falls below the commitment price.

The
first requirement is consistent with the objectives of financial
reporting described in Statement of Financial Accounting
Concepts (SFAC) 1 which states that financial reporting
should provide information about the economic resources
of an enterprise and the claims to those resources, and
information to help investors and creditors assess the amounts,
timing, and uncertainty of future cash flows. Unfortunately,
the disclosure requirements apply only to purchase commitments
associated with project financing arrangements. Because
the majority of long-term purchase commitments are not likely
to be associated with financing arrangements, investors
and creditors may be unaware of such commitments until a
loss is recognized under ARB 43.

For
example, in its 2001 financial statements, Ford Motor Company
recognized a loss of $953 million on purchase commitments
for palladium, a metal used in its catalytic converters.
During 2001, the market price of palladium had dropped from
about $1,100 per ounce in January to about $440 per ounce
by year-end, as reported by Gregory White in the Wall
Street Journal. In addition to the drop in prices,
technological advances in the design of catalytic converters
had reduced the need for palladium. Ford not only found
itself obligated to purchase palladium at prices higher
than market prices, it was also obligated to purchase the
metal in quantities it no longer needed.

Ford
makes no mention of its palladium contracts in its 2000
annual report, either in the MD&A disclosures about
commodity price risk or in the notes to the financial statements.
Ford’s only disclosure related to its palladium contracts
is a general statement about its commodity hedging program
in Note 1, “Accounting Policies,” which states,
“Ford has a commodity hedging program that uses primarily
forward contracts and options to manage the effects of changes
in commodity prices on the Automotive sector’s results.
Gains and losses are recognized in cost of sales during
the settlement period of the related transactions.”

A class
action lawsuit was brought against Ford in January 2002
alleging, among other things, that Ford’s representations
of its financial position were false and misleading, because
management had failed to disclose its loss exposure related
to the unhedged purchase commitments. The lawsuit was subsequently
dismissed by the Southern District Court of New York because
the plaintiffs did not prove that Ford had made any fraudulent
statements about its forward commodity contracts, and the
forward contracts did not represent undisclosed speculation.
Stronger disclosure requirements under SFAS 47 might have
resulted in more transparent reporting of the contracts
before the loss occurred, thus eliminating the conditions
that gave rise to the lawsuit.

While
there is room for improvement in standards related to purchase
commitments, there are no existing accounting pronouncements
that cover firm supply agreements. By their nature, firm
supply commitments entail the same kind of risk as firm
purchase commitments. In either case, the cash flow impact
of a change in prices can be substantial, but at least financial
statement users would have been made aware of any potential
losses related to purchase commitments. This is not the
casefor supply commitments.

Dugan
and Hughes (“Why Not Disclose for Supply Commitments?,”
Management Accounting, July 1991) described two
cases where firm supply agreements resulted in losses for
suppliers. During the 1960s, Westinghouse had entered into
firm agreements to supply more than 80 million pounds of
uranium to customers at an average price of $10 per pound.
The market price at the time Westinghouse entered into these
agreements was below $10 per pound, and remained below that
amount throughout the early 1970s. In 1974, after the creation
of a worldwide cartel of uranium producers, the market price
skyrocketed to $45 per pound, and Westinghouse faced potential
losses of roughly $2.275 billion. If Westinghouse had experienced
the same loss exposure from a purchase commitment, it would
have been required to recognize the entire amount of $2.275
billion in losses.

As
it was, consistent with existing accounting principles,
Westinghouse neither recognized any portion of the potential
losses in its 1974 financial statements nor disclosed the
existence of the agreements. The notes to Westinghouse’s
1975 annual report provided some disclosure about the potential
loss, but concluded that the potential loss was not reasonably
estimable. It should be noted that SFAS 5 was not effective
until fiscal year 1976, but given the 1975 disclosure note,
it is unlikely that any loss would have been recognized
in 1975 even if SFAS 5 had been in effect. As a result,
the users of Westinghouse’s financial statements were
unaware of the agreements prior to the 1975 financial statements,
and even then were kept in the dark about the magnitude
of the potential losses.

In
another case, Texaco, Inc., in its 1980 financial statements
recognized losses of $6 million related to supply commitments
and disclosed that potential losses on those commitments
could reach $815 million. Although the supply commitments
had been in effect for 20 years, their existence had never
been disclosed prior to 1980. In both cases, financial statement
users were unaware of the agreements until losses were imminent.
A simple disclosure requirement, such as that required of
companies with purchase commitments, would have alerted
financial statement users to the potential problems years
earlier.

Purchase
Commitments Versus Capital Leases

GAAP
for leases comes primarily from SFAS 13, which states that
if any one of certain criteria is met a lease contract may
be viewed, in substance, as an installment purchase of the
leased property by the lessee. Such capital leases must
be accounted for in the same manner as purchases of assets.
Accordingly, the lessee in a capital lease recognizes an
asset and a liability equal to the present value of the
payments to be made under the lease. A lease that meets
any of the following criteria is considered a capital lease:

The lease transfers ownership of the property to the lessee
by the end of the lease term.

The lease contains a bargain purchase option.

The lease term is equal to 75% or more of the estimated
economic life of the property at the beginning of the
lease term.

The present value of the minimum lease payments at the
inception of the lease is 90% or more of the fair value
of the leased asset.

The
reasoning behind the rule is that although lease contracts
are executory in nature, a lease contract that meets one
of the above criteria transfers substantially all the benefits
and risks incident to the ownership of property. One of
the primary reporting problems FASB was attempting to resolve
with SFAS 13 was off–balance-sheet financing, where
the lessee is obligated to the lessor in a manner equivalent
to a purchaser that has obtained debt-financing.

But
what about noncancelable purchase commitments where the
purchaser agrees to purchase a product over an extended
period of time? Both purchase commitments and capital leases
are executory contracts that substantively obligate the
purchaser (or lessee) to make future payments to another
party as long as the other party performs according to the
contract terms. Why should obligations under capital leases
be recognized, while information about purchase commitments
is merely disclosed only when certain criteria are met?
One possible explanation is that purchase commitments are
fully executory—that is, neither the purchaser nor
the supplier has yet performed the contract—whereas
a lease contract is only unilaterally unperformed. Under
this view, the lessor is considered to have performed its
obligations under the lease contract when possession of
the leased asset is transferred to the lessee, thus obligating
the lessee to make all future contractual payments. It should
be noted that legal remedies available to lessors in the
event of lessee default are consistent with this view.

SFAC
6 defines liabilities as probable future sacrifices of economic
benefits arising from present obligations of an entity to
transfer assets or provide services to other entities in
the future as a result of past transactions or events. FASB
also states that liabilities have three essential characteristics:

They embody a present duty that entails settlement by
probable transfer of assets at a specified or determinable
date, on the occurrence of a specified event, or on demand.

The duty is nearly unavoidable.

The transaction or other event obligating the entity has
already happened.

Clearly,
both firm purchase commitments and capital lease contracts
display the first two characteristics of a liability: They
both embody a present duty to transfer assets, and the duty
is virtually unavoidable. The distinction between the two
types of contracts would seem to be related to the third
characteristic. FASB apparently does not view the signing
of a firm purchase commitment as an event that would trigger
recognition of an asset or a liability. Such recognition
is deferred until the item is delivered. By contrast, leased
assets and their related obligations are fully recognized
at the inception of the lease, presumably because the risks
and benefits of ownership have been transferred to the lessee.

While
obligations under purchase commitments do not meet the third
characteristic of a liability, it is not certain that all
capital leases do, either. For example, in many situations,
the lessor is obligated to keep the leased asset in good
working order throughout the lease term. Such an obligation
implies a continuing economic involvement in the property
by the lessor. While the benefits of ownership may have
been transferred to the lessee, the risks of ownership have
not been fully transferred.

This
line of reasoning is not meant to suggest that leases should
not be capitalized as required under SFAS 13. Rather, it
is to make the point that noncancelable purchase commitments
are similar to leases in that both meet the first two characteristics
of a liability and neither always meets the third characteristic.
To be consistent, FASB should require disclosures as described
in SFAS 47 regarding all noncancelable purchase obligations,
not only those that meet the specified criteria. As stated
earlier, such disclosures would be consistent with the objectives
described in SFAC 1, and would have been useful to the readers
of financial statements.

Valuation
of Future Cash Outflows

An
overriding objective of initial valuation and fresh-start
valuation of assets and liabilities is to use an observable,
marketplace-determined amount. Nevertheless, accountants
often find themselves without such an objective measure
and must base valuation on future cash flows, such as in
the application of impairment accounting. For example, the
determination of the impairment loss of a plant asset requires
the estimation of future net cash flows to be generated
by the asset and then the discounting of those cash flows
in cases where there is no objective measure of the current
fair value of that asset. Although APB Opinion 21 addressed
only the valuation of notes receivable and notes payable,
it was the first standard that firmly addressed the valuation
of future cash flows at a discounted present value, and
in the years since its issuance, it has acted as a broad
principle. Recently, FASB has confirmed and expanded this
principle with SFAC 7, which states, “The objective
of using present value in an accounting measurement is to
capture, to the extent possible, the economic difference
between sets of future cash flows.” Nonetheless, there
are several areas in current GAAP where this objective is
not met, specifically, deferred income taxes, troubled debt
restructuring, and recognition of interest income under
SFAS 115.

Deferred
Income Taxes

Given
the vagaries of the Internal Revenue Code, the timing of
income tax payments often differs substantially from the
provision for income taxes under GAAP, occasionally accelerating
but most often significantly delaying the payment of taxes.
The matching principle requires that this expense be recorded
upon the recognition of the associated income. The resulting
liability is simply valued at the amount of future taxes
to be paid (i.e., not discounted).

An
argument for violating the matching principle established
under APB Opinion 21 and SFAC 7 is that the timing of the
future tax payments, related to the reversal of temporary
differences between book and tax income, is too uncertain
to be known or estimated. However, SFAS 96, which was never
implemented by most companies, would have required a scheduling
of those future tax payments. SFAS 109 calls for an estimation
of the reversal of these temporary differences in cases
where future tax rates have been changed by legislation.
This suggests that companies should be able to develop such
a schedule, which can be discounted to present value. The
objective of using present values is to capture the economic
difference between two sets of cash flows; paying taxes
today is simply not the same as paying those same taxes
next year or beyond. To be consistent with SFAC 7, income
tax expenses should reflect the economic differences that
result in the timing of those cash payments.

Troubled
Debt Restructuring

In
cases where a debtor must modify the terms of its debt arrangements
because of the risk of default, SFAS 15 has adopted some
rules at variance with the principles appearing in APB Opinion
21 and SFAC 7. Upon the modification of the terms of a debt,
there exists a new set of cash flows to which the debtor
is committed, an example of fresh-start valuation. Strict
adoption of the principle would discount that new cash flow
stream; determining a discount rate, however, is another
issue. Application of SFAC 7 would point to a rate that
reflects the current default risk—which, given the
circumstances that led to the restructuring, could be rather
high. SFAS 114 requires that the creditor discount these
same cash flows at the historical rate used to value the
original note. The historical rate is certainly more objective
than a current default risk rate would be, but the result
may be a valuation of the creditor’s receivable greater
(and possibly overvalued) than one provided by a market-based
valuation.

SFAS
15 does not require the new cash flows to be discounted
at the current default rate risk or even the historical
rate. Instead, the standard requires that, if the undiscounted
cash flows under the new modified terms are greater than
the carrying value of the debt (implying positive interest),
the interest recognized in the current and future periods
be limited to that excess. This rate often constitutes a
very low effective interest rate, lower than the historical
rate, and much lower than a rate reflective of the default
risk. If the undiscounted cash flows under the restructuring
are less than the carrying value of the note, the note is
written down, and a gain is recognized. No interest expense
is recognized in this case, and every dollar paid in the
future will be a direct reduction in the carrying value
of the note. This treatment has the effect of smoothing
the earnings of the reporting company.

An
argument for the SFAS 15 approach is that using either a
reasonable rate, or even the historical rate, to discount
the future cash flows would recognize a sizable gain by
the debtor (thus increasing net income in the year of the
restructuring), followed by periods of higher interest expense.
If the historical rate were used, it would be consistent
with the principles of APB Opinion 21 and SFAC 7, as well
as the creditor accounting treatment for this same restructuring
under SFAS 114. Furthermore, as long as the source and nature
of the resulting gain were clearly identified, the resulting
accounting would have greater representational faithfulness
and better reflect the value of the accommodation provided
by the creditor.

The
evolution of the accounting for debtor and creditor is interesting.
SFAS 15 resulted in symmetrical accounting for debtors and
creditors with respect to the modification of terms in a
troubled debt restructuring. The position taken by FASB
may have been an accommodation to financial institutions
that were facing sizable losses from their exposure to Third
World countries as well as the U.S. real estate and energy
sectors during the late 1970s. In 1993, after this political
pressure had subsided, FASB issued SFAS 114, which modified
the accounting for creditors by requiring the discounting
of the newly agreed upon cash flows at the historical rate,
thus removing the symmetrical treatment. FASB stated that
the reason for not addressing debtor accounting at that
time was that it would have delayed the issuance of the
standard.

Recognition
of Interest Income

SFAS
115 changed the method of accounting for investments in
debt and equity instruments, bringing balance sheet valuation
in line with the present-value principle of APB Opinion
21 and SFAC 7. As noted by Kathryn M. Means (“Effective
Interest … on What Basis?,” Accounting Horizons,
June 1994), however, that principle was not carried to the
income statement for the recognition of interest revenue
on debt instruments. At each balance sheet date, available-for-sale
and trading securities are reported at their current market
values; to the extent that the future cash flow has not
changed, any change in the market value must have resulted
from a change in the implied discount rate. This adoption
of market value accounting on the balance sheet therefore
incorporates the updated discount rate. Income statement
accounting is not consistent with the mandated balance sheet
accounting, because SFAS 115 requires that the interest
income continue to be recognized at the interest rate implied
by the market value of the security on the date of purchase.
Any market value adjustment account required to bring the
existing carrying value of the debt security plays no role
in determining interest income for the following accounting
period. This inconsistency is another indication that specific
rules override the consistent application of principles.

Stock
Dividends and Stock Splits

The
accounting literature describes three types of stock distributions
to common shareholders that do not involve consideration:
small stock dividends, large stock dividends, and stock
splits. While the market views these three events as substantively
equivalent, ARB 43 requires a different accounting treatment
for each type of stock distribution. FASB’s Conceptual
Framework provides little guidance in this area. SFAC
6 states that companies have traditionally classified equity
as capital stock, other contributed capital, and retained
earnings. It further states that because of certain transactions,
including stock dividends, such classifications “may
or may not accurately reflect the sources of equity of an
enterprise. However, those problems are problems of measurement
and display, not problems of definition.” SFAC 5,
which provides guidance with respect to recognition and
measurement in financial statements, is silent on the subject
of stock dividends and stock splits.

Stock
splits. ARB 43 defines a stock split as “an
issuance by a corporation of its own common shares to its
common shareholders without consideration and under conditions
indicating that such action is prompted mainly by a desire
to increase the number of outstanding shares for the purpose
of effecting a reduction in their unit market price, and,
thereby, of obtaining wider distribution and improved marketability
of the shares.” Implicit in this definition is the
assumption that in the case of stock splits, the share market
price adjusts proportionately to the number of shares issued,
and, therefore, recipients of the additional shares do not
receive dividend income. It follows that because true stock
splits neither provide dividend income to shareholders nor
have any impact on legal capital requirements, no accounting
treatment is necessary.

Large
stock dividends. ARB 43 described stock dividends
where the number of shares issued was so great that their
market value would be materially reduced as, in substance,
stock splits “effected in the form of a dividend.”
As with stock splits, because the share market price adjusts
proportionately to the number of shares issued, such large
stock dividends would not provide dividend income to the
recipients of the additional shares. Unlike pure stock splits,
however, legal capital changes in the amount of the par
value of the newly issued shares. Accordingly, the prescribed
accounting treatment is to transfer an amount equal to the
par value of shares issued from retained earnings to contributed
capital.

Small
stock dividends. According to ARB 43, small
stock dividends provide dividend income to stockholders
because the issuance of a relatively small number of shares
does not have any “apparent effect upon the share
market price, and, consequently, the market value of the
shares previously held remains substantially unchanged.”
Based on that assertion, ARB 43 requires companies to account
for small stock dividends by transferring from retained
earnings to paid-in capital an amount equal to the fair
value of the shares issued. Small stock dividends are defined
as those involving the issuance of less than 20% to 25%
of the number of shares previously outstanding.

Stock
Splits and Large Stock Dividends

There
are two reasons why no accounting treatment is prescribed
for stock splits. First, because par (or stated) values
are changed to reflect the additional shares outstanding,
stock splits do not change legal capital requirements. Second,
the Committee on Accounting Procedure (CAP) assumed that
the share price would fully adjust to reflect the additional
shares. In this case, the accounting treatment seems to
be consistent with the reasons given.

The
arguments presented in paragraph 11 of ARB 43 make it clear
that the CAP viewed stock dividends greater than 20% to
25% of outstanding shares as stock splits rather than dividends.
Unlike stock splits, however, large stock dividends cause
a change in legal capital, for which there must be an accounting.
Thus, the standard requires a transfer of an amount equal
to the par value of shares issued, from retained earnings
to common stock, to account for a large stock dividend.
While this approach seems reasonable with respect to measurement,
a question arises with respect to the charge to retained
earnings. If a large dividend is, in substance, a stock
split, it stands to reason that retained earnings should
not be affected by the transaction. Instead, the change
in legal capital would require only a transfer of an amount
equal to the par value of the additional shares from additional
paid-in capital to common stock.

Small
stock dividends and stock splits. Because
the CAP correctly asserted that large stock dividends are,
in substance, stock splits, the term “stock split”
as used below will refer to both types of transactions.
As stated above, ARB 43 requires companies to account for
small stock dividends by transferring from retained earnings
to paid-in capital an amount equal to the fair value of
the shares issued. This accounting treatment is consistent
with the CAP’s assumption that stock dividends of
less than 20% to 25% of outstanding shares do not cause
a proportionate change in stock price and, therefore, provide
income to recipients roughly equal to the market price per
share received. Subsequent
market research, however, fails to support the CAP’s
assumption about market reaction to small stock dividends.
Indeed, several research studies subsequent to the issuance
of ARB 43 provide evidence that the market does not view
either small stock dividends or large stock dividends as
dividends, but rather as splits, with stock prices fully
adjusting to the additional shares issued. Thus, while the
requirement to transfer an amount equal to the pre-dividend
market value of shares distributed to capital stock is consistent
with the CAP’s basic assumptions, such an accounting
treatment is inconsistent with the current understanding
of capital market behavior. Following the CAP’s logic
with respect to stock splits, because small stock dividends
do not provide dividend income to their recipients, small
stock dividends are in substance stock splits and should
be accounted for in the same manner as other stock splits.

In
summary, given that the market reaction to small stock dividends,
large stock dividends, and stock splits is similar, and
that none of the three types of stock distributions provides
wealth to existing stockholders in proportion to the number
of shares issued, all three should be accounted for as stock
splits and never as dividends. Accordingly, stock “dividends,”
both large and small, would be accounted for by a transfer
from additional paid-in capital to common stock, rather
than from retained earnings, equal to the par (or stated)
value of shares issued. In the case of true no-par stock,
no accounting recognition would be required.

Transparency
and Consistency

There
are several areas within GAAP discussed above where inconsistencies
in standards exist. These inconsistencies call into question
the transparency of accounting information that is based
on those standards. Such inconsistencies should be resolved,
and FASB’s Conceptual Framework should be strengthened
to minimize the possibility of issuing additional standards
that are inconsistent with each other, as well as to provide
an even more unified theoretical basis for the development
of future GAAP.

Timothy
B. Forsyth is an associate professor in the department
of accounting at Appalachian State University, Boone, N.C.
Philip R. Witmer is an associate professor,
also at Appalachian State University. Michael T. Dugan is the Ernst & Young
Professor in the Culverhouse School of Accountancy, the University
of Alabama, Tuscaloosa, Ala. The authors appreciate the helpful
comments of Ken Brackney, Bob Herz, Steve Grice, Charles Pier,
and Bill Samson.

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